Economics

Fiscal sustainability

Defying gravity

ONE of this week's new NBER working papers is a fascinating look at Japanese government debt, by Takeo Hoshi and Takatoshi Ito. I appreciate this paragraph:

Economic research has been accumulating overwhelming evidence against the fiscal sustainability of Japan. Many international financial institutions, credit rating agencies, and private-sector analysts agree over this assessment. Yet, the JGB interest rate has been low and stable. The 10-year JGB rate has been below 2% since 1999, and between 0.8% and 1.5% in the last few years. The rate is much lower than the bond rate of other advanced countries. This is despite the fact that Japan has a higher debt to GDP ratio than the European countries that have suffered from sovereign debt crises in the last two years—Greece, Ireland, Portugal, Spain, and Italy. JGB yield actually fell as the Japanese debt to GDP ratio increased in the 1990s and 2000s as Figure 3 shows. Why has the JGB yield not risen?

Overwhelming economic evidence! And yet the yield refuses to rise. Still, the frustration is understandable. Gross government debt in Japan is north of 230% of GDP, the government continues to borrow about 9% of GDP each year, and yet the yield on 30-year government debt is under 2%. How does this work?

The key to this feat appears to be the fact that the overwhelming majority of Japanese government bonds are held domestically, most of it by commercial banks and insurance companies. Some of this appetite for government bonds, among households especially, may be attributed to the fact that in a deflationary environment even low nominal rates translate into a decent real yield. Yet as Noah Smith indicates here, part of the answer is financial repression; banks are encouraged to hold government bonds to meet capital adequacy requirements, and insurance and pension funds may be herded toward government debt.

The funny thing about this repression is that it hasn't been used to erode away the value of the debt stock. If you have domestic savers locked up in government bonds, then a short burst of moderate inflation can make a signficant impact on the burden of debt. As Carmen Reinhart and Belen Sbrancia explained here, America and Britain used repression and inflation to dispatch much of their postwar debt. But Japan, of course, has not used inflation in this way. Monetary policy has been used to protect and enhance the value of savings held in government bonds rather than erode it. That may be down to political awareness of the desires of an aging population, to some extent. As the NBER paper makes clear, however, it may also be due to the potential for large bank losses if banks' enormous holdings of Japanese government debt start losing value.

So, the dynamic in Japan has been steady growth in government expenditures associated with ballooning pension and health costs but flat revenues, leading to a large deficit and growing debt. That borrowing has so far been absorbed by domestic saving, strongly encouraged by the government and then amplified by deflation. Alternatively, consumption has been suppressed. Tellingly, Japan has run a current account surplus for decades.

As the authors of the paper note, however, this model is doomed (seemingly) to end. Japanese saving rates are rapidly falling as the population ages. The share of the working-age population in Japan is plummeting, and total saving rates are falling as a result and may eventually turn negative. Correspondingly, Japan's current account surplus is shrinking fast. But Japanese government liabilities are only growing. At some point, the stock of government liabilities will grow larger than the stock of total domestic saving, so that even if everything the Japanese saved was used to buy government bonds, the government would have to rely on foreign lenders to cover some of its borrowing. Foreign investors, it is assumed, will demand better rates of return, particularly given the possible risk of eventual default. Rates will rise, and the jig will be up. The authors estimate when this point might be reached under several different scenarios. Even under optimistic assumptions, the end is only a decade away.

When the end comes, Japan's political system will have to figure out how to distribute the losses. It could try to solve its problem through large increases in taxation. Other old economies manage large welfare state costs and high rates of taxation, though those that do it successfully—Sweden is perhaps the best example—aggressively reformed their banking sectors, liberalised their economies, and deployed effective monetary policy. Japan could instead (or additionally) try to rein in growing pension costs and increase inflation, which would effectively transfer resources from old retirees to younger workers and businesses.

Of course, Japan might also opt for and stumble into default. Or, Mr Smith speculates, it could find itself propped up by aggressive buying from a mercantilist People's Bank of China. Or—getting into more outlandish suggestions—it could open itself up to immigration from abroad.

That's assuming, of course, that it doesn't continue to defy gravity. The tricky thing about Japan is that if the end really is inevitable, markets ought to anticipate that and bring it about long before Japan actually hits hard limits on domestic borrowing. And so far, that hasn't happened. Potential triggers for a flip in the equilbrium (downgrades, disasters) have come and gone without having the anticipated effect. But as they say one goes bankrupt very slowly, then all at once.

If the yen is really undergoing deflation, foreign buyers may also want such bonds, even with such interest rates, and make their money on the exchange rate change.

Also, an issue the article doesn't mention: If the interest rates are so low, then investors need a *lot* of savings for retirement, because it isn't going to grow much from compounding. This means that they can in fact buy lots of bonds...

"At some point, the stock of government liabilities will grow larger than the stock of total domestic saving, so that even if everything the Japanese saved was used to buy government bonds, the government would have to rely on foreign lenders to cover some of its borrowing. Foreign investors, it is assumed, will demand better rates of return, particularly given the possible risk of eventual default. Rates will rise, and the jig will be up."

This is a really excellent article. But it raises an interesting economic issue. Economists can predict WHAT will happen with 100% certainty, and yes, inevitably, these predicted events will occur.

But what economists have not yet managed to do is predict WHEN these events will happen. "When the bell rings".

We have not worked out the very human ability to drag things out. We can see that in Europe with the situation of Greece. We all agree Greece must leave the Euro. When this will happen, though long overdue, is unpredictable! The same will happen in Japan. The crunch will come, but given the inevitable human behavior, the consequences will be dragged out forever.

"The tricky thing about Japan is that if the end really is inevitable, markets ought to anticipate that and bring it about long before Japan actually hits hard limits on domestic borrowing."

Markets anticipate nothing. They react in a chaotic and unpredictable manner, overshoot during a bubble and during a depression. This is how commodity booms destroy wealth. In a bubble the market keeps prices artificially high for way too long. People tend to know a bubble exists well before it bursts, and yet they keep on buying, because bubbles always go on for much longer than expected. When the bubble bursts, it is the market catching up with reality, not anticipating anything.

I am not saying that Japanese government debt is a bubble, but it does seem to fit the general case. It is the herd mentality going on with what worked before despite mounting evidence that it is unsustainable.

Default through inflation hurts the poor and lower middle class the hardest, because they depend mostly on wages, which inflation erodes. The wealthy have many ways to profit from inflation, such as buying land, stocks foreign bonds, etc.

Outright default hurts those who hold the bonds at the time of default. In Japan's case that would be the banks and insurance companies as well as their stockholders, usually the wealthy.

Europe cannot duplicate this move without the consent of all member countries. The ECB will not purchase Euro-government bonds from moribund economies whilst Germany, having to pick up the bill, dissents.

fundamentalist below makes a good point as well. Over time, Japan has accumulated claims against foreigners, which it could start drawing down even if domestic savings start drying up due to a rising dependency ratio.

However, isn't default thru inflation more feasible if most debt is held externally? That is, visibly eroding the value of assets held by voters tends to have a lot more negative career effects for a politician than eroding the value of assets held by foreigners (who can't vote). That would seem to make Japan's looming problem less amenible to the default thru inflation approach than a country with lots of external debt.

"That's assuming, of course, that it doesn't continue to defy gravity. The tricky thing about Japan is that if the end really is inevitable, markets ought to anticipate that and bring it about long before Japan actually hits hard limits on domestic borrowing."

Why? THe market, collectively, is a group of individuals who while intelligent individually, are together quite stupid and easy to manipulate by those who have the money and know-how.

"The key to this feat appears to be the fact that the overwhelming majority of Japanese government bonds are held domestically"

So, if the Chinese started buying $1 trillion in Japanese government debt, yields would fall?

Best solution here is for japan to generate 2-3 percent inflation and restore growth, at which point their debt problems will be perfectly manageable. More likely they will raise taxes and cut spending, and remained stuck...

Inflation defaulting wasn't slow for the UK in the '70s - and it was devastating, and that is despite high underlying productivity growth, a demographic dividend, abundant cheap energy and so many other positive drives.

Japan's far worse fiscal situation, and far worse demographic/ productivity prospects (relative to the UK in the 1970s), mean that Japan will suffer hell in comparison (probably closer to Greece than what Britain experienced).

For the US, there is a real danger in taking reserve currency status for granted. There are non-trivial risks:
1)
The eurozone forms a banking union, becomes more stable and issues some kind of eurobond. Bulgaria, Romania, Lithuania, Latvia, Hungary and Poland all join the euro while continuing rapid catch up growth, and countries principally trading with Europe (Russia, Turkey, the Middle East, North Africa) continue to increasingly denominate trade in euros. The CFA franc zone (the 14 West African countries which have used the CFA franc essentially since WWII - which is fixed to the euro) becomes more economically significant. All of this would strongly increase both demand and supply of euro denominated assets/ reserves, and somewhat undermine the dollar's reserve currency status. Single big moves, like eurobond issue or the opening of euro-denominated oil exchanges, could have a big and relatively sudden impact.

However ridiculous that scenario might seem, it isn't. 39.1% of all foreign exchange transactions include euros, while 84.9% include dollars (the total adds up to 200%). The dollar has been rapidly losing share, while the euro has gained share in recent years, for denomination of international trade. And eurozone muddling through and continued expansion remains the most likely outcome. Latvia/ Lithuania are set to join by 2015, while Romania and Bulgaria are especially keen to join as soon as Mastricht convergence criteria can be met.

2)
China liberalises it's financial markets. First, that means an end in the mass purchase of sovereign bonds - fairly devastating for US treasury bond yields. Second, combined with continued economic growth, that means increased denomination of international trade in Yuan. It also means that countries trading most with China (e.g. big oil exporters) increasingly seek to hold reserves and sovereign wealth in yuan denominated assets. All of this badly hits demand for US treasury bonds. Again, financial market liberalisation can happen quite suddenly.

3)
As authoritarian governments fall in the Middle East, or as oil prices fall, or as governments feel the need to buy political support, sovereign wealth fund demand for treasuries will dry up. A similar prospect in the case of China is also relevant here - though probably much less likely.

4)
Inflation will eventually begin to pick up, QE will have to stop/ slow down, and the demand for treasury bonds will fall.

5)
The very Japan default event that the article discusses would prompt Japan to sell a large part of it's $1.1 trillion in treasury holdings.http://www.treasury.gov/resource-center/data-chart-center/tic/Documents/...
At over 20% of all foreign holdings, that would be one hell of a shock to treasury yields (perhaps compensated for by a "flight to safety" - but only of the dollar still holds that status. That is, the dollar might pay a price in this scenario if debt has grown and if the yuan or euro are open stable alternatives).

If some of the above events happen, even only in part, yields on treasuries might rise pretty quickly.

If reserve currency status had encouraged the US to build an unbearable debt before that time, there remains the risk of an exceptionally painful inflation/ default/ depression event.

America isn't at risk yet - probably by a decent margin. But however painful, that deficit must be brought down. Preferably through structural reform and reducing future obligations - but some substantial current deficit cutting will still be necessary over the next two or so years.

Caveat: when the deficit is going to be cut, give the Fed an advance warning. By a full year. And make the commitment impossible to exit. Don't hit the fiscal cliff - the Fed must be given advance warning so that it can compensate with monetary expansion to (as well as possible) sustain demand and minimise pain.

Its called supply and demand for JGBs. There are a lot of public entities purchasing these bonds, keeping their prices high and yields low. The Bank of Japan also buys these bonds, adding massive amounts to bank reserves, which keeps the supply of money to the banking system flush and interest rates low.

The Fed in the US is duplicating these moves, keeping bank reserves flush and interest rates very low. Until the policies change in both countries, it shall just be years of languishing economies.

you seem to think that no country can live long with a stable/falling population and that immigration is the cure of all ills. well that is an unsustainable philosophy by definition. better start thinking of new ways to cope with falling populations other getting the shortfall in from other places. what about when the world population stabilizes? get them in from elsewhere?
saying that japan shhould open up to immigration to sort out its ills is a simplistic policy. please dish up something (much) more original to stop us from yawning when reading The Economist.

The problem will take care of itself as Japan's elderly quit working and begin to live off savings. More spending and less savings will drive up inflation. A current account deficit will force interest rates up.